The Efficient Market Hypothesis is Flawed

May 2nd, 2012 by 
PK

The Efficient Market hypothesis is an excellent control and null hypothesis, but breaks down a fair amount of the time in markets - and not just the financial ones.

Are you an active or a passive investor?  As with all things in finance (such as the type of investor you are), there are shades of gray, but you can basically break down investing strategies into one of those two categories.

On the one hand, you have the passive investors, the buy and hold guys (and gals).  Usually this crew has a portfolio strategy, like a 60%/40% stock/bond mix, a "Coffeehouse" portfolio, or some other sort of indexing scheme.  Expect it to be well thought out, back-tested, and generally a decent fit for you low information investors I discussed in my last post.

On the other hand?  'Frequent' traders, who are traders of individual stocks and people who are using instruments more complex or volatile than ETFs and Mutual Funds.

Information Asymmetry and Warfare

Buy and hold has a huge following - and the truth is, it should. The vast majority of investors shouldn't bother with anything more than a passive portfolio - "set it and forget it" is an awesome strategy that won't keep you awake at night worrying too much about recent volatility.

Although the massive diversification of most buy and hold schemes means that while you capture large swings in the market, you won't capture the outsized returns which are possible with individual stocks.  Balance that against the greater risk of outsized drops and you recognize the power of passivity.  If you read the previous article I wrote on investor psychology, anyone in the low information category should seriously consider this style.

Even though buy and hold likely commands the most followers, there are tons of passionate investors of an active persuasion.    The tools of the trade in active investing include technical analysis, valuation, momentum trading and all sorts of sub discipline which inform the purchases and sales of individual securities (and sometimes other asset classes like ETFs).  Active traders move in and out of the market more often than passive investors, and even though they are a minority of investors, they capture a majority of press.  It makes sense though - that minority makes the majority of trades - they move the market on a day to day basis, even if their passive friends set the foundation.

The Efficient Market Hypothesis (EMH)

In the passive corner, the strongest evidence there is that what they are doing is optimal is the theory known as the Efficient Market Hypothesis (and its various offshoots, such as CAPM).

Basically, the Efficient Market Hypothesis says that there can be no edge in the market, that investors are all perfectly rational, and all investors working off public information can't profit except from inside information (and even then, maybe not), and that all stocks are equally well priced.  There are various degrees of strictness of the theory, but the main point is that the market works like a  Random Walk Down Wall Street.

Passive investing's spokesmen and women will point to sheer randomness and luck whenever they are presented with evidence of someone beating the market over a long period of time.  Consider the following... assume you have a 1 in 2 chance of beating the market in any given year.  If that is true, you can see that the odds of you beating the market quickly reduce over a period of years.  However, in a universe where there are 150,000,000 investors investing randomly, getting the 'coinflips' right 25 times in a row still leaves 4-5 'investors' who we will now treat as gurus based on sheer luck.  Therefore, we should discount anyone who seems to be lucky, not skilled, over a long period of time.

At this point, a note: In my last article, I gave you a list of people who actually did beat the S&P 500 over a long period of time.  Let me repeat some of them here: Benjamin Graham, David Dodd, Warren Buffett, Irving Kahn, and Walter Schloss.

Why did I pick those specific investors?  Some of you already might recognize that they were either teachers or students of Ben Graham and David Dodd's value methods, authors of the famous book Security Analysis (and its companion The Intelligent Investor).  Keep that in mind for the next section.

Three Strikes Against the Efficient Market Hypothesis

I don't consider myself a particularly active investor.

Whenever I buy a stock I try to figure out valuation (what it 'should' be priced) to calculate a potential upside.  When a stock is close to fairly valued?  That's when I sell.  This process of buy and hold isn't quite the same as passive portfolios as it requires I keep an eye on a number of metrics, but since my holding periods are generally measured in years I don't exactly consider myself an active investor.  I don't belong in either camp.

That said, I can't accept all of the things stated by the EMH.  Assuming rationality is a wonderful way to come up with a framework for how the markets work and to approximate the movements of the market, but extrapolating one rational being's decision making to an entire market (where it's possible that the most active investors are the least rational) is too much to swallow.  Let's talk about three reasons the EMH falls short:

  1. The Efficient Market Hypothesis assumes that all markets reflect the fair value of all stocks quoted, discounting all publicly available information.  Since at one point before the currently quoted price there was a different price, in order for the current price to be accurate some trader had to have captured the difference in prices in order for the current price quote to be accurate.  He or she may have bought or sold stock to increase/lower the price, but since the price moved, someone must have profited off of it.  Simply, a market participant forced the move to the current price, so someone captured the difference from fair value.
  2. The EMH's 'weak' formulation allows for the occasional flash crash like 1987's black Monday, but no great answer has emerged as to how, in a rational market, bubbles form and pop.  In what efficient market could an asset have wild swings in price from day to day in the virtual absence of news?  On a smaller scale, why do markets tend to overshoot on surprise bad or good news, only to rebound in the opposite direction?  Examples abound in the latter category - BP during the recent oil spill, Alcoa during the tobacco lawsuits, even banks during the recent recession (although some of that bank mojo, but not all, is government intervention).
  3. Just above I laid out the odds of investors beating the market over long periods of time.  How have 5 value oriented investors - when we said 5 completely random investors would be expected, perhaps, from odds alone - beat the market over such a long period of time?  Note that Graham started teaching value investing in 1928 - so you're talking about his methods prevailing over an absurd period of 84 years at this point (a far cry more than 25 years).  Having proponents of the same theory all outperforming the market is the third strike for the EMH.

What Could Beat the Random Walk Style of Investing?

If you agree that the EMH is flawed, you're probably wondering 'what can possibly beat random walk investing'?  That's simple, it can be one of three things:

  1. A leading indicator of future performance which hasn't yet been recognized.  The ultimate example is the price/sales ratio, first popularized by Ken Fisher of Fisher Investments fame.
  2. An asset class which is more likely to be overlooked, misunderstood or ignored by the market.  The ultimate example of this would be small capitalization stocks.  The definition varies, but generally large funds will avoid buying stakes in smaller stocks (they don't want to 'accidentally' buy voting control, or they have institutional controls preventing it).  Another recent example would be mortgage backed securities - where a number of investors found a way to make a killing while the market tanked.
  3. A methodology which requires work or a personality trait which isn't present in other investors.  This is where value investing falls into the mix - since fund returns are measured on a quarterly and yearly basis, an individual investor can out-wait a large fund, which has to impress investors quarter after quarter.  Value investors might under-perform for years only to gain many years worth of returns in a few months - any funds attempting that sort of strategy would be closed well beforehand.  Another example is activist investing and private equity, where extreme amounts of work can lean down a company and cause it to reevaluate things, improving outlook at a firm.

Do You Have Any Specific Evidence to Support This?

Efficient Market Hypothesis vs. the CAPE

The Efficient Market Hypothesis versus the Shiller P/E Ratio

The most famous example is probably Robert Schiller's, when he graphed the P/E10 (the average price to earnings of the S&P 500 over the rolling ten year period) versus earnings.  That graph clearly shows a negative correlation with high valuations and returns... in essence, valuation works on the market as a whole to inform decisions on how and when to invest.

I mentioned Private Equity.  Is there any evidence activist investing and private equity beats the market?  Well, yes, again there is plenty of evidence.  (As a side note, I don't know why Mr. Arends is so angry about this study - the PE firms are putting up their capital and doing lots of work restructuring these firms, so you'd hope they can capture some excess returns).

How about small caps beating the market?  Here's what I've got.  I could dig around for other asset classes too, but you can use Google just as easily as I can.  As for people making money on misunderstood asset classes, like say, by shorting mortgage backed securities?  I'd go with Michael Lewis's The Big Short.

And valuation methods which aren't yet widely known in the larger market?  Do a bit of reading on Ken Fisher and you'll see that as his PSR became well known its predictive value started to fall - an important point for anything that can fall into category 1 above.

All of that points to one conclusion: there is a way to beat the market.  It may be temporary, it may be difficult, and it may take patience - but there has to be a way.  Even if that 'way' can be captured by only 1% of investors, the Efficient Market Hypothesis is still disproved.

Do you consider yourself an active or a passive investor?  What do you think of the Efficient Market Hypothesis?  Can market be 'beat'?  What's your strategy for investing?

      

PK

PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK lives in New Hampshire with his wife, kids, and dog.

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